Hybrids securities come home to roost

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It’s not just consumer and real estate loans that have wreaked havoc on the banking system, but another favorite financial product championed by big banks during the boom years: hybrid securities.

The Wall Street Journal reports that these securities, which are a blend of equity and debt, helped fell six family-controlled Illinois banks that imploded last week. During the boom, hybrid securities, or trust preferred securities, became a perfect product for banks that wanted to raise funds that would count toward their Tier 1 capital cushion without diluting common shareholders. Investors who typically invested in debt loved hybrids because they offered higher yields at a time of extraordinary low returns in traditional investments like corporate debt.

The securities became a pariah, however, when they stopped paying dividends.

From the WSJ article:

The six failed banks, some of which were founded in the Civil War era, had about $1.38 billion in combined assets. While the Federal Deposit Insurance Corp. found buyers for the banks’ branches and some of their loans, the failures are expected to cost the agency’s strapped insurance fund roughly $267 million. A total of 52 federally insured banks and savings institutions have gone bust this year.

The Campbell family still controls three banks that remain in business. Two are based in Illinois and also have been battered by investments in trust preferred securities. A third bank, in Scottsdale, Ariz., steered clear of the securities because it had plenty of growth opportunities through lending. It is now suffering from a wave of souring loans to finance commercial real-estate projects.

But the Campbell family didn’t just buy hybrids, they bought the sliced and diced collateralized debt obligation version, thinking that such a risk dispersion would insulate the banks against potential losses.

This is all sounding painfully familiar. It’s also a reminder that the need for regulation that goes well beyond consumer financial products. As reports that Wall Street banks are warming up the securitization machine with new products, regulators need to take a close look to make sure that the new brand of financial engineering isn’t the same old house of cards with fresh paint.